Penn West Petroleum: This Bad Boy Is Cheap… But Risky

Remember a few weeks ago when I touched on Penn West Petroleum while talking about coin flip investing? No? Anyone? Y’all suck. That post was gold. You’re going to want to go back and read that, because this post is going to show you just how such a phenomenon works.

Like the rest of the investing world, I’ve watched oil melt down over the last few months. Yes, apparently I get that channel in South Korea. I watched it fall to $85, then $80, and now finally to $76, or whatever it finished at yesterday. The market is concerned that supply is OUT OF CONTROL while demand is waning. The supply imbalance is partly due to the huge increase in shale drilling in the U.S., our oil sands expanding faster than my ego, and Russia pumping out all the oil it can. Tensions with ISIS in Iraq aren’t even helping, since apparently the group is using oil proceeds to fund its crimes against freedom.

You know what ISIS needs? DUBYA to come kick some ass.

Put all this together, and there’s a glut of new oil in the market. If you’re OPEC, what exactly should you do?

So far… not much. There are rumors that the Saudis are happy to let oil stay low for a while, but I’m not sure if I buy them. Out of the dozen or so OPEC members, only 3 can run a balanced budget based on oil prices at today’s levels. Sure, running a deficit for a year isn’t the end of the world, but the much easier solution is to just cut production to get oil back up to $85-$90 a barrel. It’s what OPEC has done just about every time this happens. Sure, Russia might not cooperate, but everyone else should. Putin is just too badass to play by the rules.

Any excuse I can I’m gonna use this picture.

(Edit: Russia isn’t even in OPEC. Oh well. Putin stays. You try saying no to a shirtless man on a bear.)

All signs point to oil rebounding pretty hard when OPEC does get together and talk about things at the end of the month. There might be a few countries opposed, but it looks likely. Nobody wants to see oil below $80. Shale plays can’t make money, oil sands plays are marginally profitable depending on the location (old mine are, while new ones aren’t, essentially), and any offshore stuff is approximately break even, depending on where it is.

So I went sniffing around the sector. Canadian Oil Sands was a name I first checked out. It has a monstrous dividend yield, currently north of 8%. It’s also just finishing up a couple of major projects to its upgrader system, meaning that its capex expenses are going to drop from something like $600 million in 2014 to $200 million in 2015. If oil stabilizes around $85, the dividend is safe, but not if oil stays below $80.

What I didn’t like about COS is that it’s a pretty high cost producer. Suncor’s oil sands plays are, overall, a lower cost, but you’re only getting a 3% dividend to own it compared to 8%. And since Suncor is so big, many investors have cycled out of the riskier names into it. That always happens when a sector gets killed. Thus it doesn’t represent the upside opportunity as a riskier name.

So that led me to Penn West, which has had years of terrible management, ill-timed acquisitions, and dividend cuts weighing it down. I’ll leave it to you to research the history of it, but let’s just say the accounting scandal that hit it this summer was like a cherry on top of a sundae of crap.

Ah, the accounting scandal. Here’s what happened. The previous CFO “accidentally” led the accounting department to state operational expenses as capital expenses. This action inflated cash flow, which was then reported to investors. The new CFO came in and caught the problem, leading to a complete forensic accounting investigation. Results for 2012-13 were restated, resulting in a $145 million decrease in funds flow.

Now, I can already hear everyone’s reaction. ACCOUNTING SHENANIGANS?!?!?! RUN AWAY AND THEN BURN IT WITH FIRE. Here’s why I think that’s a bit of an overreaction.

The difference between operational costs and capital costs can be a fine line sometimes.

The guy in charge back then is gone. In fact, most of the management team has been replaced.

The new CFO took action immediately. No sweeping it under the rug.

Uh, hello? Buying opportunity.

Now that the accounting scandal is wrapped up, Penn West can get back to the pressing matter of decreasing its debt. Over the past year it’s been working, with net borrowings falling from $3 billion to $2.1 billion after June 30th, with probably another $300-$400 million being paid down from asset sales. The company is aggressively selling natural gas assets and using the cash to pay down debt.

Out of the $2.1 billion remaining (most of this is in U.S. Dollars, which makes it a little harder, fyi), $500 million of it comes due in 2016 while the rest is good until 2019. And it just sold assets worth $355 million. So even if oil stays low, Penn West should be good to pay off the 2016 debt.

Even though the company’s equity to debt ratio is pretty close to 1:1, debt shouldn’t be a problem, at least until 2019. Even if things get dodgy, the company can eliminate the dividend (more on that later) and save $200-$250 million per year.

The assets

Here’s the crux of buying Penn West. There are some really good assets mixed in with the crap it overpaid for.

The company blew its brains out acquiring natural gas assets in 2010, pretty much at the worst possible time. Results suffered as gas prices stayed weak, and the rest is history. Part of management’s turnaround plan is to get rid of the gas assets and focus on light oil production in three main areas in Alberta that I’m too lazy to look up. They’re good fields though.

Because of the asset sales, production has shrunk considerably. Daily production used to be 150,000 boe/d, which has fallen to 105,000 boe/d lately. Quarterly results are due out tomorrow, but expect more of the same.

Management projects production to grow between 5-10% annually starting in 2015 as its investments in these three main fields start to take off. Plus the bulk of the asset sales are now done.

A quick look at the balance sheet shows a company with assets of $11.8 billion, less $1.8 billion of goodwill, which we’ll assume is all but gone. Total liabilities are $4.4 billion. Penn West’s market cap is $2.3 billion. Thus, investors are getting $5.6 billion in book value for $2.3 billion. That’s a 59% discount to book.

Penn West bears will say that the assets are crap. Okay, some of them probably are. Even after management’s turnaround plan, the company will still have natural gas assets. But are they so bad that they’re not even worth half of what management thinks, even after stripping out the goodwill? The debt is making this company really cheap.

Possible risks

We’ve already talked about why I think oil prices will increase, but what happens if they don’t? Management has come out and said that at $80 oil it can make enough to cover the dividend and the capital expenditures planned… but just barely. Anything less than $80 and Penn West starts to get into trouble.

The current dividend is $0.14/quarter, a huge 12.1% yield on a stock which trades at $4.64. I’m not sure why management hasn’t eliminated it yet, but don’t even consider it. Unless oil pops back up in a hurry, the dividend is going to get cut again. I’d eliminate it flat out and use the proceeds to pay debt if I was in charge, but I understand there are still a lot of retail investors who hold this company for the succulent dividend. It’ll probably go lower if the dividend is cut.

The stock is at an all-time low. Again, unless oil bounces back in a big way, tax loss selling will keep it depressed through the end of the year. I wouldn’t get too excited about it quite yet.

Possible upside

Book value (less goodwill) is $11.31 per share. Again, this is a $4.64 stock. The spread here is huge.

If the company can get back to book value, you’re looking at an upside of 244%. Most oil companies trade at anywhere from 1.5-3.0x book. If Penn West can ever trade at 1.5x book value again, you’re looking at an upside of 365%. Yes, there is the possibility that lower oil prices push the stock to zero, but I think the odds are much higher that oil recovers and so does Penn West.

And that’s about it. I will be patient with this stock, but I rate it a buy right now. I’ll be looking to pick some up at some point in the future.